Chapter 11

1. Chapter 11 Controlling Inventory and Production Costs

2. Learning Objectives 1. Why do managers use ABC inventory control systems? 2. How does a company determine from whom, how much, and when to order? C11

3. Continuing . . . Learning Objectives 3. What are the differences between the economic order quantity model and materials requirements planning? 4. What is the JIT philosophy and how does it affect production? C11

4. Continuing . . . Learning Objectives 5. What is the impact of flexible manufacturing systems on production and on satisfying customers? 6. How would the traditional accounting system change if a JIT inventory system were adopted? (Appendices 1 and 2) C11

5. Continuing . . . Learning Objectives 7. How does the product life cycle influence sales and costs? (Appendix 3) C11

6. $$$ Costs Associated with Inventory:Purchasing or Production Purchasing Production • Quoted price Direct material • - Discounts allowed + Direct labor • + Shipping charges +Traceable overhead • + Insurance charges +Allocated fixed overhead • while items are • in transit

7. 12 9 3 6 Costs Associated with Inventory:Ordering or Setup Ordering Setup Invoice preparation Labor time receipt & inspection Machine downtime Payment Forms Clerical processing

8. Costs Associated with Inventory:Carrying or Not Carrying (Stockout) Not Carrying (Stockout) Carrying Storage Lost customer goodwill Handling Lost contribution margin Insurance charges Ordering & shipping Property taxes charges from filling Losses from obsolescence, special orders damage, and theft Setup costs for rescheduled Opportunity cost of production invested capital

9. Decisions in Purchasing Inventory In purchasing inventory, a purchasing manager needs to make three primary decisions. • What supplier? • What quantity? • When to order?

10. $ Traditional Supplier Relationship Decision based primarily on price!

11. Partnership Viewof New Buyer-Supplier Relations Views cost in relation to quality and reliability

12. Changes in Buyer-Supplier Relationship • Number of vendors reduced to limited group • Selected based on quality, reliability, price • Quality certification • Long-term contracts • Develop better communications • Site visits • Assure quality and service • Obtain quantity discounts • Order size reduced • Frequency of delivery increased • Reduce operating costs

13. Economic Order Quantity AFTER the supplier is selected  2 Q O C EOQ = Estimate of number of units per order that would provide the optimal balance between ordering and carrying costs

14. Example Quantity needed per year (Q) = 4,200 tons Cost of ordering (O) = $30 per order Cost of carrying (C) = $10 per ton Uses 15 tons of pulp wood per day Supplier can deliver in 3 days Maximum quantity used per day is 19 tons

15. Economic Order Quantity  2 Q O C EOQ =  2 (4,200) $30 $10 EOQ = EOQ = 159 (rounded)

16. Total Inventory Costs Carrying Costs: (159  2) x $10 = $ 795 Ordering Costs: (4,200  159) x $30 792 Total Inventory Costs $1,587 =====

17. Questions to Ask Before Ordering • Is storage space a limited resource? • How critical is the item to production? • How critical is cash flow? • Can units be ordered in the quantity indicated?

18. When to Order Safety Stock = (Maximum Usage - Normal Usage) x Lead Time = ( 19 - 15) x 3 = 12 tons Order Point = (Daily Usage x Lead Time) + Safety Stock = ( 15 x 3) + 12 = 57 tons

19. Problems with EOQ Model • Is difficult to identify all relevant inventory costs • Does not provide any direction for managers attempting to control individual types of purchasing and carrying costs • Ignores relationships among inventory items

20. Materials Requirements Planning • What items are needed? • How many of them are needed? • When are they needed? Answers the questions:

21. Steps in an MRP System • Sales forecast used to develop a master production schedule (MPS) • Computer MRP model generates a time-sequenced schedule for purchases and production component needs using • Product bill of materials and operations flow document • Inventory balances • Lead time

22. Continuing . . . Steps in an MRP System Work load compared with capacity; bottlenecks identified • MRP program run again until all bottlenecks accounted for

23. MRP IIManufacturing Resource Planning Plans production jobs using MRP AND calculates resource needs such as labor and machine hours Involves manufacturing, marketing, and finance

24. Push System WIP Storage Purchases WIP Storage Work Center FG Storage Work Center Work Center Materials Storage Sales

25. Just-In-Time Systems Three primary goals • Eliminating any production process or operation that does not add value to the product/service • Continuously improving production/ performance efficiency • Reducing the total cost of production/ performance while increasing quality

26. Elements of JIT Philosophy • Eliminate as much inventory and storage space as possible • Keep lead time short by using frequent deliveries • Use creative thinking to find ways to reduce costs • Work to eliminate defects and scrap

27. Continuing . . . Elements ofJIT Philosophy • Establish good relationships with suppliers • Listen to employees • Train employees to be multiskilled and increase productivity • Constantly look for ways to improve operations

28. Pull System Work Center Purchases Work Center Work Center Sales

29. Product Processing • Reduce machine setup time • New equipment • Training • Implement highest quality standards and focus on goal of zero defects • Quality determined on continuous basis • Vendor product quality • Quality in conversion process • Modern production equipment

30. Traditional Manufacturing Plant Layout WIP WIP WIP F i n i s h e d M G o o d s a t e r i a l s WIP WIP WIP

31. Just-In-TimeManufacturing Plant Layout F i n i s h e d M G o o d s a t e r i a l s

32. Employee Empowerment • Put the right people in the right jobs • Make training an ongoing process • Provide employees with necessary tools • Equipment • Information • Authority • Training • Push decision-making authority and responsibility down to lowest reasonable level • Establish atmosphere of trust among all employees at all levels

33. Seven Steps to Implement a JIT System 1. Determine how well products, materials, or services are delivered now. 2. Determine how customers define superior service, and set priorities accordingly. 3. Establish specific priorities for distribution (and possibly purchasing) functions to meet customer needs. 4. Collaborate with and educate managers and employees to refine objectives and to prepare for implementation of JIT.

34. Continuing . . . Seven Steps to Implement a JIT System 5. Execute a pilot implementation project and evaluate its results. 6. Refine the JIT delivery program and execute it company wide. 7. Monitor progress, adjust objectives over time, and always strive for excellence.

35. Important Relationships Every company has a set of upstream suppliers and a set of downstream customers. In a one-on-one context, these parties can be depicted in the following model: Upstream Supplier The Company Downstream Customer

36. Continuing . . . Important Relationships Consider the following opportunities for improvement between entities: • improved communication of requirements and specifications • greater clarity in requests for products or services • improved feedback regarding unsatisfactory products or services • improvements in planning, controlling, and problem solving • shared managerial and technical expertise, supervision, and training

37. Flexible Manufacturing Systems A flexible manufacturing system (FMS) is a network of robots and material conveyance devices monitored and controlled by computers. Two or more FMSs connected by a host computer and an information networking system are generally referred to as computer integrated manufacturing (CIM).

38. Comparison of Traditional Manufacturing and FMS TRADITIONAL Information requirements Batch-based On-line, real-time Product variety Low Basically unlimited Response time to market needs Slow Rapid Worker tasks Specialized Diverse Production runs Long Short Lot sizes Massive Small FACTORMANUFACTURINGFMS

39. Continuing . . . Comparison of Traditional Manufacturing and FMS TRADITIONAL Basis of performance rewards Individual Team Setups Slow and expensive Fast and inexpensive Product life cycle expectation Long Short Work area control Centralized Decentralized Technology Labor-intensive Technology- intensive Worker knowledge of technology Low to medium Highly trained FACTORMANUFACTURINGFMS

40. Accounting Implications of JIT • End-of-period variance reporting and analysis essentially disappears • Variances recognized on the spot • Two comparison standards: annual and current • Use conversion costs rather than labor and overhead • Inventory accounting • Raw and In Process (RIP) Inventory account

41. Backflush Costing • Streamlined cost accounting method that speeds up, simplifies, and reduces accounting effort • During period, records purchases of materials and accumulates conversion costs • At completion or sale, total costs incurred recorded to cost of goods sold and finished goods inventory using standard production costs

42. Continuing . . . Backflush Costing Bernard Company’s standard production cost per unit: Direct material $ 75 Conversion 184 Total costs $259 ==== No beginning inventories exist.

43. Continuing . . . Backflush Costing (1): Raw and In Process Inventory 1,530,000 Accounts Payable 1,530,000 Purchased $1,530,000 of direct materials in June.

44. Continuing . . . Backflush Costing (2): Conversion Costs 3,687,000 Various accounts 3,687,000 Incurred $3,687,000 of conversion costs in June.

45. Continuing . . . Backflush Costing (3): Finished Goods Inventory 5,180,000 Raw and In Process Inventory 1,500,000 Conversion Costs 3,680,000 Completed 20,000 units of production in June.

46. Continuing . . . Backflush Costing (4): Cost of Goods Sold 5,128,200 Finished Goods Inventory 5,128,200 Accounts Receivable 8,316,000 Sales 8,316,000 Sold 19,800 units having a cost of $259 per unit on account in June for $420.

47. Continuing . . . Backflush Costing Ending Inventories: Raw and In Process ($1,530,000 - $1,500,000) $30,000 Finished Goods ($5,180,000 - $5,128,200) 51,800 In addition, there are underapplied conversion costs of $7,000 ($3,687,000 - $3,680,000).